The Magic Formula for Biotech

If you're a busy investor with more than just stock-picking on your plate, you might want to consider a mechanical investing strategy. And if you're interested in stocks, one of the most intriguing of these strategies is Joel Greenblatt's Magic Formula.

Greenblatt details this approach in his enriching, funny The Little Book That Beats the Market. His strategy revolves around two factors:

How cheap is the stock?

How profitable is the company?

This simplified approach really boils down value investing to its essence. When you find a company whose price fails to reflect its high profits, you might have a winner.

A cheap business and a profitable companyTo find cheap companies, the Magic Formula looks for a high earnings yield -- basically, a company's EBIT divided by its enterprise value. EBIT is earnings before interest and taxes, otherwise known as operating earnings. Enterprise value includes the company's market capitalization and then adds its net debt. In general, the higher the earnings yield, the better. The Magic Formula looks for a yield higher than 10%.

To find profitable companies, Greenblatt's Magic Formula seeks businesses that generate pre-tax returns on assets (ROA) greater than 25%. In other words, for every $100 in assets it holds, the company would produce at least $25 in net profit. In general, the higher the ROA, the better the business. Greenblatt looks for companies with an ROA higher than 25%.

Going by the Magic Formula criteria, only Gilead Sciences meets both standards, but Amgen also exceeds the Formula's desired 10% earnings yield and Biogen is within 5 percentage points of offering the Formula's desired 25% ROA.

While biotech and pharma stocks can be strong performers, they are not the types of investments that you can just buy and ignore. Their success relies on strong performance from year to year, and the rapidly changing nature of the industry doesn't allow any of these companies to rest on their laurels.

Amgen is seeking to gain FDA approval for the use of its Xgeva drug on patients who have not yet suffered bone metastases, with a decision due from the FDA by April 26. The ability to expand the use of Xgeva would improve Amgen's competitive advantage by allowing patients to take its drug before using Provenge or Taxotere, which belong to rival companies Dendreon and Sanofi. In addition, while many of its industry peers fail to offer a dividend, Amgen offers a current yield of 2.2%.

Celgene has shown some nice growth in a tough economy over the past year, although 70% of its revenue is generated by its blockbuster drug Revlimid. The drug has increased the life span of those who take it, but there have been some concerns that it may increase the incidence of secondary cancers. Although later studies showed that this risk was small and applied only to patients who have undergone stem-cell transplants, the 10% crash in the stock price following the initial report demonstrates the risk attached to overreliance on one drug.

Gilead Sciences dominates the HIV drug market, with two of its drugs claiming 75% of the market share in the U.S. and 50% of the global market share. However, as the patents for these drugs come closer to expiring, Gilead needs to push some new blockbuster drugs down the pipeline. Gilead is also working to develop some new drugs in the hepatitis C market, but it must compete with companies like Vertex Pharmaceuticals and Merck, which have a head start. However, its recent purchase of Pharmasset, which just developed an oral treatment for hepatitis C that doesn't require interferon, making it lack the nasty side effects of current treatments, may put Gilead in a better position to compete. It is also worth noting that while Gilead does not offer a dividend, it makes good use of its extra cash to increase shareholder value by buying back shares periodically.

Foolish bottom lineThe key advantage of the Magic Formula is speedy decision-making. You can run a screen, mechanically buy the stocks, then spend your free time doing the activities you love. However, such an approach means that you need to pick a lot of stocks (say, 25 or 30), since you haven't performed any strategic analysis of your investments. According to the formula, you should hold the stocks for one year to receive favorable tax treatment, sell all of them, and then run the screen again to find your new picks.

Although this approach sounds easy, Greenblatt cautions that it can be tough to stick with during hard times. In some years, this mechanical strategy simply won't work. However, Greenblatt's extensive backtesting suggests that over the long haul, his Magic Formula can significantly outperform the market.